Introduction
New Keynesian Economics is currently the most popular mainstream economic theory. It’s assumptions, equations and conclusions are the intellectual rational for most government advisors and central bank policy makers in the Western world, meaning that for better or for worse, this theory is loose in the real world.
This blog series aims to do to two things. Firstly, it’s a 101 class into understanding New Keynesian Economics, with key assumptions and equations laid out in as jargon free manner as possible. Secondly, it’s a ground up critique of a theory that has more holes than a kitchen cullender. You can learn the math, the key assumptions and key flaws as we explore this theory from the ground up.
Table of Contents
Overview
This introduction article aims to provide a brief overview of New Keynesian Economics, giving a 10,000 foot view of the overall structure and history of the theory. Later posts are more technical and detailed, this blog is just to set the scene.
History & Background – Why is it called New Keynesian?
Before explaining an overview of New Keynesian Economics, it is important to understand its evolution and origin. New Keynesian Economics receives its name because it is widely considered to be a synthesis of two highly opposing views, that of New Classical Economics and Keynesian Economics. This statement may seem straightforward, but we are already into a controversy.
There is no doubt that one of the main forerunners of New Keynesian Economics is New Classical Economics, which believes that supply and demand will always balance and that people are all rational, utility maximizing individuals.
But where is the ‘Keynesian Economics’ element of this synthesised theory? It can be strongly argued that the Keynesian element is missing.
Keynesian Economics (as fully described by Keynes himself) was a powerful argument for demand side economics (in short, the view that the government needs to spend to maintain aggregate demand to keep the economy running and everyone working). But whereas Keynes believed that demand should be boosted by direct government spending, New Keynesian Economists generally prefer to increase demand via influencing the amount of money invested by businesses (done by manipulating the interest rate). This was part of Keynes theoretical framework, but he did not believe businesses responded so strongly to the interest rate change that business investment could be an adequate replacement for outright government spending.
Hence the argument as to New Keynesian Economics origin, ‘true Keynesians’ consider it not to capture the essence of Keynes argument, which was a focus on government spending rather than monetary policy (in this case influencing the interest rate to alter business investment levels).
Structure of New keynesian Economics
New Keynesian Economists believe that you need to look at the economy in two different time frames: the short-run and the long-run. The idea is that certain conditions hold true in the long-run but not the short-run, and vice versa. Hence New Keynesian’s have developed two different approaches to modelling the economy, and the one you choose depends on the time frame you’re interested in. There is no clear time boundary between the short-run and the long-run, but these models can produce very different predictions.
When to Use the Long-run or the Short-run
How do we know when to use the long-run model instead of the short-run? The simple answer is if you think people have enough time to fully respond to news, then you can use the long-run models to predict economic outcomes. For instance, if oil prices have suddenly gone up then many firms may not be able to change their prices immediately, which means they can’t respond. If it takes a year for all firms to adjust their prices to the oil shock, then the long-run is the appropriate view when looking one year and beyond into the future. If you’re trying to figure out what’s going to happen in the next twelve months, then the short-run is more useful.
Long-run- a Brief Introduction
In New Classical Economics the long-run is the natural state of the economy (levels of GDP, inflation, unemployment, etc.) that exists due to the production capacity of the economy. It works on the idea that we have factories and workers, and that because demand will always equal supply everything produced will be bought. This means that everyone who wants a job can have a job (if they lower their wage expectations enough) and everything companies produce will be bought (if they lower their prices enough). That sounds pretty simple, but unfortunately we know that demand doesn’t always match supply, that there are sometimes many unemployed people such as in the 2008 Great Recession, and that factories often sit empty or underutilised. This is where the short-run comes in.
Short-run – a Brief Introduction
New Keynesian Economists believe that the economy can easily be knocked out of it’s long run balance. This could swing both ways, with the economy ending up producing more than it has capacity for (with everyone employed and then being paid to work overtime) or the economy producing less than it has capacity for (with some people unemployed due to the lack of demand). The reasons for this are the most complex bit of New Keynesian Economics by far, and will be discussed in detail in later articles.